Price adjustments under fixed exchange rate, Microeconomics

Assignment Help:

PRICE ADJUSTMENTS UNDER FIXED EXCHANGE RATE:

In a flexible exchange rate regime trade deficits (surpluses) are automatically corrected by a depreciation (appreciation) of a country's currency. On the other hand, in a fixed exchange rate regime, disequilibrium conditions are corrected by changes in domestic prices. A deficit reduces the country's money supply which in turn reduces the prices. The reduction in the country's money supply will tend to increase the interest rate, which in turn dampens the investment and thereby reduces aggregate demand. Consequently, price level will fall which will encourage exports and discourage imports.

At the same time, higher interest rate induces capital inflows that would help in financing the deficit. he process of price adjustment under the fixed exchange rate regime is similar to that of the price adjustment under the gold standard, i.e., price-specie-flow- mechanism. Under gold standard, a country's currency is defined by the gold content. This is to say that a country will be ready to buy or sell any amount of gold at that price. Further, as the gold content in one unit of currency is fixed, exchange rates will also be fixed. For example, assume that a £1 gold coin in the UK contains 113.0016 grains of pure gold, while a $1 gold coin in the US contains 23.22 grains of gold. This implies that the exchange rate ($/£) is 4.87 (i.e., 113.0016 ÷ 23.22). Assuming no shipping costs,
exchange rate will be stable unless there is a change in the gold reserves of any country. 

This is because no one will be willing to pay more than $4.87 for a £1 coin as gold worth of $4.87 can be purchased in the US and exchange it for £1 in the UK. Similarly gold worth £1 can be purchased in the UK and exchanged for $4.87 in the US. These gold outflows/inflows measure the size of Balance of Payment deficit/surplus. 

In a deficit situation, the automatic adjustment mechanism is as follows: With gold outflows under trade deficit, country's money supply will fall, which in turn, triggers a fall in internal prices. As a result, exports will be encouraged and imports will be discouraged until the deficit in BoP is eliminated. 

This adjustment mechanism operates in a similar manner even if a country is not following a gold standard. The foreign exchange reserves held by a country is akin to the gold reserves. As such, disequilibrium in trade flows will be reflected in the changes in the foreign exchange reserves which in turn influences the money supply and thereby the domestic prices.


Related Discussions:- Price adjustments under fixed exchange rate

Explain how a country can peg its currency, Explain how a country can peg (...

Explain how a country can peg (fix) its currency to another currency. Explanation of a pegged/fixed currency should centre on how the central bank uses the currency market mech

Required the Detail Answer, Sir i am the student of MSC Economcis frin Dust...

Sir i am the student of MSC Economcis frin Dustabce University (AIOU)from Islamabad (Pakistan)my name is Mohammed Bilal Farooq and required the answer of the following questions Q

Economic theory, Much of undergraduate macroeconomic theory is discussed on...

Much of undergraduate macroeconomic theory is discussed on the assumption that, in the short run, the expectations of economic agents about the future values of macroeconomic varia

Evalution - credit and recoveries, "Micron" is a company,providing micro fi...

"Micron" is a company,providing micro financing facility for various business entities.So far Micron has been in operation for seven years facilitating new business ventures and ex

Demand, what is ment by demand

what is ment by demand

Point elasticity of demand, solution for calculate price elasticity of dema...

solution for calculate price elasticity of demand for demand function Q= 10 - 2p for decrease in price from Rs. 3 to Rs.2..

Marketing, how distribution is arranged to provide customer service

how distribution is arranged to provide customer service

Gas laws, What is the resultant pressure if 2.7 mol of ideal gas at 273 K a...

What is the resultant pressure if 2.7 mol of ideal gas at 273 K and 2.51 atm in a closed container of constant volume is heated to 399 K

Microeconomics, Ways in which the markets fail and discuss why government i...

Ways in which the markets fail and discuss why government intervention is justified and whether government intervention works or not.

#t, what are the relevance of economics to most business today??

what are the relevance of economics to most business today??

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd